ESG Investing: The remarkable rise of sustainable investments

Sustainable investing started 15 years ago as means of mitigating risk. However, it really took off about a decade ago, partly driven by the calamity that was the 2008 global financial crisis.

Improved disclosure requirements on environmental, social and governance (ESG) risks were seen as integral to improving transparency and rebuilding the banking and financial systems. Today, this has become one of the hottest topics in the global asset management industry.

Sustainable investing is considered an umbrella term for investments that seek both adequate financial returns as well as a long-term positive impact on the community and environment.

Morningstar director of passive strategies and sustainability research Hortense Bioy says individuals and institutions have started to incorporate ESG factors into their investment decisions for a variety of reasons — be it to mitigate risk, identify opportunities or align their investments with their personal value systems. The global financial crisis, among others, showed investors and asset owners that they needed to take a long-term approach to investing, she adds. “They understood that they could no longer only focus on the near future.”

As they started to evaluate their long-term objectives, it became apparent that their investments were not just affected by financial and economic sentiments but also seemingly unrelated challenges such as climate change, population growth, natural resource scarcity and socio-economic woes, says Bioy.

“Even the central banks are talking about climate change now. They are looking at the implications of such challenges to their loan books,” she says, referring to the 2017 Network for Greening the Financial System pact launched by Bank of England governor Mark Carney and signed by 46 central banks and regulators.

“Before the prevalence of social media and advanced data-accumulating technologies, most people never saw the impact of their businesses or investments. But now they do. They do not want to invest in companies that pollute rivers, treat their customers poorly, fail to promote gender diversity, engage in child labour and more. These issues have become reputational risks for companies.”

Investors and asset owners are increasingly aware that for a brighter economic future, there needs to be greater transparency, a shift in investment culture, a rebuilding of consumer confidence and asserting public accountability, says Julie Moret, global head of ESG at Franklin Templeton Investments.

“ESG is not just about ethics, values or screening. It is about how one taps into this wider pool of information to integrate that along with financial analysis to really understand the vulnerabilities to businesses — the risks but also the opportunities,” she adds.

Issues to do with governance were traditionally the primary drivers pushing asset owners to consider sustainable investing measures, says Paul Milon, ESG specialist (Asia-Pacific) at BNP Paribas Asset Management in Hong Kong. “But today, a lot of the attention on ESG issues is on climate change, with well-known initiatives such as Climate Action 100+, and increasing momentum for the Taskforce on Climate-related Financial Disclosure recommendations.

“We also believe there is a need to look at the energy transition as well as broader sustainability issues (natural capital, including water and deforestation) as well as the need for a more equal and inclusive economic mode.”

He adds that the growing number of natural disasters, to say nothing of rising levels of pollution, have shown that ESG issues are increasingly material, not only in the long term but also on shorter investment horizons.

Fiduciary duty

A variety of sustainable investing strategies have been around for decades. But in the past, the focus was on screening out investments in industries that did not gel with investors’ values such as weapons, tobacco, gambling and adult entertainment. The downside was that this approach limited the number of companies available for investment and was seen as an impediment to building an optimal portfolio.

In 2004, United Nations Secretary-General Kofi Annan invited 50 CEOs of major financial institutions to participate in a joint initiative supported by the UN Global Compact, International Finance Corporation and Swiss government to find ways to integrate ESG into capital markets. And the interest in ESG-related investments continue to grow.

Each ESG-related fund tackles the issue differently. Some tilt portfolios toward sustainability leaders while others focus on weeding out the laggards. Others target companies that demonstrate improving sustainability characteristics, says Bioy.

“I believe that exclusion is a blunt-force instrument. This is the main reason we do not do exclusions or divestments. We feel that you lose your voice at the table when you cannot engage with these companies,” says Moret.

However, Franklin Templeton adheres to strict exclusions when it comes to companies dealing with controversial weapons, she adds.

“The climate transition story, for example, is about enabling future productivity and the corporations in the energy business still continue with their businesses while transitioning to cleaner and more energy-efficient sources. So, we will look at metrics such as carbon emissions, disclosures on climate and whether the company is committing to reducing carbon emissions,” says Moret.

For those who shied away from reporting on these risks, claiming that their fiduciary duties were limited to the maximisation of shareholder value, there is more than enough evidence to show that ESG issues do have financial implications, says Bioy. “In many developed markets, including the US and the EU, ESG integration is increasingly seen as part of fiduciary duty.”

Growth potential

Assets defined as ESG, sustainable or socially responsible investments reached US$30.7 trillion at the start of 2018, with growth seen in Canada, the US and Japan.

According to the Global Sustainable Investment Alliance’s biennial report — Global Sustainable Investment Review 2018, released in April — sustainable investment assets grew 34% from January 2016 to January 2018. The statistic is based on data collated from regional market studies of sustainable investment forums in Europe, the US, Japan, Canada, Australia and New Zealand.

Europe still accounts for the largest share of global sustainable investment assets at US$14.1 trillion. In fact, Morningstar’s 3Q2019 review showed that the European sustainable fund universe attracted inflows of €24.9 billion (RM114.9 billion), 71% of which were taken by active funds.

The review also showed that sustainable index-tracking open-end funds and exchange-traded funds continued to take a greater share of net new money at 29% in 3Q2019 from 22% in the previous quarter.

“As at end-June, we had identified 2,232 open-end and exchange-traded funds domiciled in Europe that fit our sustainable fund criteria,” says Bioy.

In Malaysia, ESG adoption began taking shape in 2018 as some of the country’s large asset owners, namely the Employees Provident Fund, Kumpulan Wang Persaraan (Diperbadankan) and Khazanah Nasional Bhd became signatories of the UN Principles for Responsible Investment, demonstrating their commitment to responsible investments to advocate for a more sustainable financial system.

Bioy points out that regulators globally are determined to ensure that the private sector is preparing for climate change shocks. In 2018, the European Commission, for example, released its Action Plan for Financing Sustainable Growth. This included proposals for a taxonomy on climate change; environmentally and socially sustainable activities; standards and labels for sustainable financial products; support for sustainable infrastructure; mainstreaming ESG factors into market research and credit ratings; exploring how corporate governance can better enable sustainable finance; and enhanced oversight of sustainability by the European Supervisory Authorities.

On the home front, Bursa Malaysia was one of the earliest bourses in the region to introduce an ethical investment stock market index in the FTSE4Good Bursa Malaysia Index, which supports investors in making sustainable investments in local public-listed companies. The index currently has 71 constituents compared with 24 when it was launched in 2014.

Last month, the Securities Commission Malaysia released the Sustainable and Responsible Investment (SRI) Roadmap for the Malaysian capital markets, aimed at creating an SRI ecosystem and charting the role of the capital markets in driving sustainable development.

There is increasing evidence that taking a more holisitic view on investments is financially rewarding. BNP Paribas’ Milon says numerous studies have proved that companies with superior sustainability practices generate better long-term financial performance. The Financial Times, quoting the Boston Consulting Group, reported that more than 300 of the world’s largest pharmaceutical, consumer goods, oil and gas, banking and technology companies with more ethical operations were more profitable.

Milon believes in the “active stewardship” approach, where companies with lower ESG standards today and are making the effort to improve will outperform their peers when they do.

Bioy says looking at ESG issues are no longer an option but the way forward. “The more we wait, the more difficult it becomes to tackle these issues. We have to act now. Otherwise, it will be too late for your investments and the planet.”